The Week Ahead: Expect stocks to take a breather. The Treasury market counts.
Pessimists own bonds. Optimists own equities. This old definition surfaced in the last few days. The rout started in government bonds. Ten-Year Treasuries rose from 1.6% to 2.3% and the 30-Year Treasury hit 3.0% for the first time in a year.
But corporate spreads did not widen. So, post-election sentiment seems to be inflation up, borrowing costs higher, inflation and a solid outlook for businesses and equities. We'll admit to practicing cautious optimism, which leaves us somewhat on the fence. Why?
MARKETS MOVE FAST: here are some of the 10-day price swings we’ve seen. Get ready.
What to make of these?
1. Some of these are classic hedge trades. In many models and algorithms, if safe assets weaken (Treasuries), the model sells down. This weakens the asset more. Turtles all the way down.
2. We suspect many hedge funds and short money are working their way out of positions taken ahead of the election. As few people predicted the outcome, our bet is that many traders lost money.
3. Many investors missed the equity move in 2016. This was a last chance to get back in ahead of year-end. Last week, $21bn flowed into equity ETFs (and 20% of that into small cap and tech) whilst $4bn came out of bond ETFs.
4. Some trades made little sense. Fine, if you think inflation’s a risk, then buy into stocks and TIPS. But gold usually follows inflation fears and that fell. And if you think your currency is about to reflate, you would sell against the stronger currencies. But no. Here’s the dollar in recent days:
That’s a 7% to 13% increase against some of the country’s major trading partners. Sure, it helps the inflation outlook but expect some major hurt for S&P 500 companies. Remember, 40% of S&P 500 company sales are overseas.
AND INFLATION: The consensus is that taxes will fall, consumers spend and infrastructure investment creates inflation. A couple of views on this. First, yes, increased inflation is not a good sign and an uptick usually precedes a recession.
But last week’s inflation numbers were very benign at 1.6% and 2.1% for core (i.e. no food and energy). There are signs of rapid increases in healthcare inflation but it’s tough to see where across the board, higher and growing inflation will come from. Here's the broader Producer Price inflation from midweek.
Inflation could increase from these levels and, indeed, given low base effects from 2015, we expect some 2% prints over the next few months. But holding it back are some pretty strong forces:
- The Fed, which has only intermittently allowed inflation to surpass 2% in the last 25 years.
- Fiscal spending in the U.S. in 2009 utterly failed to create inflation.
- Dollar strength
- A high level of corporate and household debt. These have grown 32% and 27% in less than three years. Any change in debt servicing is likely to curb spending on everything from discretionary to corporate buy backs.
WHERE DO RATES GO? Clearly they have backed up fast in the last 10 days. Janet Yellen repeated on Thursday that any rate increases would be gradual. We believe her. The market is looking ahead to greater issuance, a possible and inflationary trade war and general all around unpredictability. Pessimists at work. We'll save you another graph, except to say the sell-off looks overdone.
BOTTOM LINE: We're generally fine with the exposure to U.S. stocks and especially U.S. small cap stocks. We have liked the domestic part of the economy for a while and small and mid caps had underperformed for a while coming into 2016. The Treasury market remains a short-term concern but we don't believe we should trade into a weak market.
TPP hegemony passes from U.S.
The cost of deportation
Takes a while, but SEC gets their man
--Christian Thwaites, Brouwer & Janachowski, LLC
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All charts from Factset unless otherwise noted.